FEATURE: Finance frontline

Even if you are an economist, it is difficult to get your head around the global financial crisis. There are different theories about what caused it, and no-one really knows how it will all end.

Jonathan Gadir

Last Updated: Thu, 15 Jan 2009 17:32:00 +1100

To understand what happened last year, you have to start by understanding how mortgages in the US turned into something which helped ruin the whole world economy.

In turn, that means understanding a part of the financial markets usually hidden from public view - the bond markets.

Jonathan Gadir set out to talk to people working as traders and fund managers in the bond markets, exploring their views of what happened, and the role of "financial engineering" in the meltdown of 2008.

Story Transcript

JONATHAN GADIR: Hardly anybody predicted the financial meltdown. Now afterwards, everyone has a theory about why it happened.

But the comedians John Bird and John Fortune seemed to know what would happen. Their skit on subprime mortgages aired on British television back in October 2007.

(excerpt from the skit)

JOHN BIRD: Well the thing is, let's say things are going along as normal in the market. And then suddenly, out of the blue, one of these very sharp and sophisticated people say, "My God! Something awful is going to happen! We've lost everything! Oh, my God, what are we going to do, what are we going to do?

JOHN FORTUNE: Shall I jump out of the window?

JOHN BIRD: Shall I jump out of the window. Exactly! Let's all jump out of the window! Sell!

JOHN FORTUNE: We've got to...sell!

JOHN BIRD: Sell! Sell!

JOHN BIRD: Sell!

JOHN FORTUNE: Sell! Sell!

JOHN BIRD: Sell. Yes, precisely.

(audience laughing)

JOHN BIRD: And then a few days later, this same sophisticated person says, "You know, I think things are going rather well." And everybody says, "You know actually, I think I agree with you." "You know, I think we're rich." "We're rich." "Yes!"

JOHN FORTUNE: Rich, yes. Buy, buy, buy!

JOHN BIRD: Buy, buy, buy! Yes. And that is what we call market sentiment.

(end of excerpt)

JONATHAN GADIR: That's the funny side of it, to get the serious stuff, I went to Sydney's CBD.

Frontline for the financial markets is a bunch of swish city office towers usually near Circular Quay, usually with a good view of Sydney Harbour. The headquarters of numerous global banks, investment banks, brokerage firms, and fund managers.

To understand what happened this year, you have to start by understanding how mortgages given to people in the US who couldn't make their repayments, turned into something which helped ruin the whole world economy. And to understand that, I had to talk to people working in one particular part of the financial market.

So this part of the market is the part that's not the share-market. It's the part of the market that was normally in the shadows until 2008.

The name is Bond.

SEAN: If the bank needs to borrow money or if a corporation needs to borrow money, they might issue bonds, which will then pay some sort of regular interest rate and as a fund manager, you might buy those bonds which then will pay a regular return.

JONATHAN GADIR: That's Sean Carmody. I came across a blog he writes called 'A Stubborn Mule's Perspective'.

I discovered his day job was at the Australian arm of a big global fund manager, as head of the fixed income section. Fixed income means bonds and financial products like it.

He manages money on behalf of clients like the big superannuation funds.

So I emailed Sean and he agreed to talk to me in a Sydney cafe one morning before work. So long as I left his company's name out of it.

SEAN: Typically, it's large institutions that are buying them. It's certainly possible to buy these things as an individual, but it's more high net worth individuals who might be inclined to buy bonds. Because the minimum size that you can buy tend to be quite large. So half a million dollars or something like that. So, the most common purchase of these sorts of bonds would be a fund manager.

So, you effectively might be investing in these for your superannuation.

At the moment we've been taking a lot of calls from our clients just to explain to them what's been going on around the world, and some of that's quite reactive. So we've had problems with subprime mortgage-backed securities in the US.

So we've had lots of calls from investors saying, are there any subprime mortgage-backed securities in any of the funds? And really, they're obviously trying to do their duty and so they're passing all those questions to fund managers that they have their money allocated with.

JONATHAN GADIR: Before we get into what happened this year let's complete our picture of this part of the financial markets.

Sean Carmody's background is in pure maths. In fact he's got a PhD in pure maths. There's an industry word for people like him too.

SEAN: Quants. Quantitative analysts, or quants for short.

So when I got into the financial markets in the mid-90s. There'd been a big increase in the amount of use of computers and mathematical models used to analyse financial instruments and derivatives and options. Those sorts of things. And a lot of the mathematical models we used were very similar to things that we used in engineering or physics. And at that time, there weren't a lot of people in the financial industry who had expertise in that area.

JONATHAN GADIR: If Sean needs to buy and sell bonds, he might call a guy like Andrew.

ANDREW: Our clients are fund managers, money managers, pension fund managers, super accounts. Basically we provide an intermediary role.

JONATHAN GADIR: Andrew is a fixed income sales person at a global investment bank. Talking to Andrew, it was the same deal - meet at a cafe, no company name, please.

ANDREW: So, basically we're there to buy and sell and quote two-way prices, less so now, of course. But to provide pricing so that money managers can get in and out of bonds and other types of products efficiently, quickly and without too much price disturbance.

JONATHAN GADIR: The skill set for trading is different from the skill set for being a sales person.

If Sean wanted to buy or sell corporate bonds and called a sales guy like Andrew at one of Australia's biggest banks, that sales guy would consult with a colleague of his who actually does the trading, a guy like Pierre.

PIERRE: You might buy something, hold it for awhile. You might one thing from a client and sell them something else that's in your book. You might buy a certain amount and only sell off a certain amount. So there is a risk in intermediation, warehousing risk.

JONATHAN GADIR: Pierre is in charge of a team of traders at a bank, and his team focus on corporate bonds and related financial products, as opposed to government bonds.

PIERRE: Most of the markets that we deal in are what we call OTC or 'over the counter' markets. So there's no exchange, and you know, you're on the phone and if someone wants to sell you something, what's the price, here's your price, you're done. Okay? And that's a transaction. For compliance purposes, those transactions are then settled or confirmed in a back office away from the dealing businesses.

JONATHAN GADIR: Sean Carmody, the fund manager, had a finely-honed sense of how to get a good price from banks, when you're trading bonds.

SEAN: Very often, you will have to get on the phone and you might sometimes want to try and go to a few different banks and then get the best price. But you might also want to be a bit careful about how you do that because if you go and speak to a whole lot of banks at once, they might all get the sense that there's a lot of selling pressure on that particular bond, so they might not show you a very good price.

So it's a bit of a balancing act, that you want to go to as many banks as you can to make sure that you're getting the best price without spooking the market that there's a whole lot of bonds for sale.

JONATHAN GADIR: The principles are not so different from buying and selling anything else I suppose.

SEAN CARMODY: That's right, I mean, in some ways it's not so different from selling a house or anything else.

JONATHAN GADIR: Sean Carmody, the fund manager.

So back to how mortgages in the US ruined the world economy.

There's a type of bond called a 'mortgage backed security'. What happens is a bank pools hundreds of mortgages and uses the income stream from all those hundreds of monthly mortgage repayments and sells it to an investment bank which creates a company. In the jargon, a 'special purpose entity'. That company's assets are the mortgage repayments.

The company issues tradable securities. The performance of those securities is linked to the performance of the company's assets. In this case, the money from the mortgage repayments. This process is called 'securitisation'.

If you still don't get it, I'll let these guys explain.

(excerpt from a skit)

JOHN BIRD: Well then this debt, this mortgage, this debt is taken, bought by a bank and packaged together on Wall Street with a lot of other similar debts.

JOHN FORTUNE: Without going into much detail about what is actually...

JOHN BIRD: Without going into any detail. No, that's far too boring. And so this is put into a package of debt and then it's moved on to Wall Street and this is, it's extraordinary what happens and somehow, this package of dodgy debts stops being a package of dodgy debts and starts being called a Structured Investment Vehicle.

JOHN FORTUNE: An SIV?

JOHN BIRD: An SIV, exactly.

JOHN FORTUNE: Yes, I see, and then someone like you, comes along and buys it.

JOHN BIRD: I buy it, yes. And I'll ring up somebody in Tokyo and say, "Look, I've got this package, do you want to buy it?" And they'll say, "What's in it?" I'll say, "I haven't got the faintest idea." And they say, "How much do you want for it?" and I'll say, "I want $100 million dollars," and then they say, "Fine."

That's it. So that's the market.

(end of excerpt)

JONATHAN GADIR: Comedians John Bird and John Fortune in October 2007.

So why would banks want to do this securitisation stuff in the first place?

Pierre, the corporate bond trader from the bank, filled me in.

PIERRE: Capital gets freed up. So, securitising the pool is effectively moving a lot of that risk off the bank's balance sheet and frees up capital to go and do further lending.

Another aspect is potentially funding. So obviously the bank is handing over cash to those mortgage borrowers - by selling the securities via this structure it's also potentially raising cash.

JONATHAN GADIR: The mortgage-backed securities can themselves be pooled and turned into another tradable security. For example, a collateralised debt obligation.

PIERRE: CDOs, collateralised debt obligations. The way that I think about CDOs is that they're not a product, they are a technology. CDO technology can be applied to anything. It can be applied to mortgages, it can be applied to corporate bonds. It can be applied to loans, it's a technology that can apply to a number of different asset classes.

JONATHAN GADIR: This technology, as Pierre called it, is all fairly recent. Dating to the late-80s at the earliest. In fact, the explosive growth in CDOs is triggered by an innovation in risk modelling as recently as 2001.

A new mathematical formula called a Gaussian Copula.

And then, everything changed.

The US housing market dived. Losses mounted on those mortgage-backed securities. Banks were slow to admit how much mortgage-backed securities and related derivatives they held, which led to a breakdown of trust in the markets. And eventually to the big bank and the corporate collapses of 2008.

And then there was the fact a lot of the money invested in these securities was borrowed money.

Sean Carmody, the fund manager.

SEAN: Think about borrowing to buy shares or think about borrowing to buy a house, if you borrow a whole lot of money and then make an investment and only put a small amount of money in yourself, if that asset goes up, you can stand to make a lot of money.

But if the asset falls in value, you suddenly end up owing more money than your house is worth or your shares are worth. And that's a very difficult situation to be in.

JONATHAN GADIR: Andrew, the fixed income sales guy from the investment bank has a good way of explaining what happened.

ANDREW: It's a bit like the guy who goes into the bar and he has 10 drinks quickly and then he asks for two more and the barman says, "Look, don't you think you've had enough?" He says "You know, you'd be drinking like this too if you had what I had." And he said, "What you got?" "A $1.50". Right? So, basically, that's how the banks have operated. They had very little money but they were buying a lot of things.

So the capital positions were too low and they were used to finance an amount of assets which was too high. So, the leverage ratio, which is the relationship between the assets you hold and the debt you have to fund them, was just getting out of hand.

SEAN: We had a long phase where there was just a chase for yield and return. And we've obviously left that behind and gone from the phase of greed to the phase of fear.

JONATHAN GADIR: So, what counts as a good day?

SEAN: Well, what counts as a good day for us at the moment? For us as a fund manager a good day is one where we don't have a lot of money pulled out of the fund and we don't have severe losses on the fund.

One of the biggest problems we've been facing is the extreme lack of liquidity. So, what that means is that if you want to sell some bonds, it's very hard to find anyone who's prepared to buy them from you.

JONATHAN GADIR: Sean Carmody, the fund manager.

Andrew from the investment bank is also finding the going tough.

ANDREW: I would say it's interesting and frustrating. I'll be able to tell my grandkids that I worked during this time because this is, this is unprecedented and in my almost two decades in the market, I've not seen anything that approaches this.

We can come up with as many trade ideas as we want right now, and the problem is, actually getting the trade on. It's harder to come up with good ideas that actually trade. Whereas 15 months ago, you could do this rather regularly.

JONATHAN GADIR: Forgive my naivety, but when you say "good ideas that actually trade", isn't there just buy and sell? What other good ideas are there?

ANDREW: Oh, no. There are lots of different types of things you can do. Buying and selling are the easiest forms of it of course. But one is switching between two different bonds or two different bonds of different types. Or you can do what's called "butterfly trades" or "box trades".

A butterfly has three legs and one of them is called a body - you might buy the body, for example. You might buy a five-year bond and you might sell a two-year bond and a 10-year bond.

JONATHAN GADIR: I was tempted to chase the butterflies with Andrew, but he had to get back to the trading desk.

Instead, I kept chasing after who or what was to blame for the financial meltdown. One answer surprised me.

It came from Pierre, the corporate bond trader from one of Australia's biggest banks.

You thought transparency and honest accounting was a good thing, right?

PIERRE: Well, some time ago there was a new accounting standard put out. It was an accounting standard that required organisations that held different kinds of securities to be much more transparent in the way that they valued these securities in a concept we call "mark to market".

So, if you own and asset, and you own that asset and you paid $10 for that asset, so think about a share, it doesn't matter what the asset is, and if that asset is now trading at $8. So I bought it for $10 and now it's at $8. If I had to sell it, I have to sell it at $8. I don't sell it, right? But I still have that asset for $10 on my portfolio.

However, I potentially have a $2 loss. That $2 loss is what we call "mark to market". So, if I was to sell the asset, then I would have to realise a loss of $2. But I don't sell the asset, so I don't lose any real money.

Now, the new accounting standards that came out required organisations to actually report that loss. Right? And that mark to market unrealised loss forms the basis of the large losses and write-downs that we're actually seeing and that we were seeing over the last year.

Positions that aren't necessarily going to generate a real realised loss. If I held this asset until maturity and I didn't' realise any loss, today I actually I have to tell the world that I potentially have to lose money on this if I have to sell it. But I'm under no obligation to sell it.

So, it's a long way of me saying that a reasonable amount of blame has got to be placed at the feet of accountants that wanted much larger transparency on these portfolios by forcing these organisations to disclose the mark to market, the unrealised loss, of these assets.

It's compounded by the fact that in my example of owning an asset at $10 and it's currently valued at $8, if someone away from me happened to transact that asset at $5, let me call it a "distressed seller" that desperately needed to raise cash. I now in fact have to mark that position at a $5 loss, right? But in order for that to generate the downfall of an organisation, I think is probably going overboard.

JONATHAN GADIR: Does your argument assume that people are too dumb to look at the reality and they kind of get scared by the numbers?

PIERRE: Yeah, I think that's exactly. I don't think it's being dumb, I think it's when an American bank comes out and says, you know, they are about to write-down $20 billion this quarter, I'm not suggesting the markets are too dumb to look through that.

But when those numbers are so large, it then develops its own sense of, it develops its own life. In a framework that didn't require them necessarily to mark prices at fire sale, those losses wouldn't be so large.

JONATHAN GADIR: And there wouldn't be as much fear and that fear wouldn't feed on itself?

PIERRE: Bang. Exactly.

JONATHAN GADIR: That's Pierre, the head of a team of corporate bond traders at one of Australia's biggest banks.

So what about those financial products we talked about, those securities, mortgage-backed or otherwise? Isn't everyone saying that they spread the contagion, that they were responsible for amplifying the risks and the losses?

PIERRE: I mean the basis of these products, the process that allows products like these to grow, it's almost like a field in finance. It's called financial engineering.

Financial engineering is a broad terms that's kind of relates to how to turn one thing into another thing, how to make it more efficient, or how to squeeze more return out of it - to have a particular pay-off if a particular even occurred and so on.

So, obviously there's a risk that products are developed that either don't work, that have unintended consequences or that generate too much leverage or too much risk for the return and all that sort of things. And I think that's what's happened here.

JONATHAN GADIR: After hearing about financial engineering, I realised that Sean, the fund manager with a PhD in pure maths, the quantitative analyst, was a member of the professional group that does financial engineering.

I got him on the phone for one last question.

Does your profession as a whole, for quantitative analysts and financial engineers, need to take some moral responsibility for the financial meltdown?

SEAN: Um, let's see. When you try to sort of use terms like "moral responsibility" that sort of suggests that there was a decision made to do something that at the time could have reasonably been seen to be inappropriate. Many individual decisions in isolation might have seemed reasonable but then when you add it up, across the whole globe, the whole system becomes too leveraged.

In a way it's a bit like walking on the grass or something like that. If one person walks across it's not a problem but if everybody walks across, you'll soon find that there's no grass. So it's kind of a scale effect and I think when you have that sort of scale effect, it's hard to sort of say any one person should have known that these assumptions would turn out to be wrong.

In fact, the people who were structuring these things and modelling them were caught out just as unawares as anyone else in the market.